sycamore wrote: ↑
Mon Feb 24, 2020 8:50 pm
That says TIPS are adjusted for actual inflation as measured by a specific CPI index. Does that cover "expected and unexpected inflation" ?
In a word, yes. Expected
inflation is just someone's (usually "the market's") prediction
of what inflation will be over a given future time period. Actual
inflation is a measurement of the inflation that actually occurred
in a given past time period. Unexpected
inflation is just a term used to describe the difference between the two.
TIPS are adjusted for actual (measured) inflation. Regular Treasury bonds are not adjusted for inflation at all (expected, actual, or otherwise), but they make up for it by having a somewhat higher yield. Choosing between them involves predicting what inflation will be.
Let's say you give me the choice between a 10-year regular Treasury bond yielding 2.0%, and a 10-year TIPS yielding 0.5% above inflation. If I think that inflation will be 1% over that period, I should choose the regular bond, since I would end up with more money that way. If I think that inflation will be 2% over that period, I should choose the TIPS. If I think that inflation will be 1.5%, I might call it a toss-up.
In real life, no one asks you to choose between a 2% bond or 0.5% TIPS -- the market adjusts those percentages up and down in real time, depending on what people are choosing to buy. Regardless of where the numbers come to rest, the difference between them is an indicator of what the market as a whole
expects inflation to be for the given time period. That's what we refer to as "expected inflation" or the "inflation breakeven rate".
But expected inflation is just a guess. Once the time period's over, you'll know for sure what you should have bought. If actual inflation ended up being higher than what the market expected, you should have bought the TIPS. If actual inflation ended up being lower than what the market expected, you should have bought the regular Treasury.